What are the factors that drive high energy prices and market instability?

In June and July 2022, various events contributed to extremely high energy prices and market instability that resulted in the suspension of trading and price caps to try and bring the crisis under control.

The current energy crisis reared its head shortly after the last Federal Election in May 2022, as international and domestic pressures combined to drive an unprecedented price hike for wholesale electricity and gas.

The rapidly deteriorating situation came to a head on 1 July, when the Australian Energy Market Operator invoked the Gas Supply Guarantee (GSG) for the first time.

On 15 June, AEMO suspended the wholesale electricity market in all regions of the NEM and manually determined spot prices, allowing participants to apply for compensation if those prices did not cover their costs.

On 22 June, AEMO removed the $300/MWh administered price cap and lifted the market suspension the following day.

But the crisis was not contained, and on 19 July, AEMO again invoked the GSG to ensure supply adequacy.

In its Wholesale Markets Quarterly Report for Q2, the Australian Energy Regulator said publicly traded futures contracts suggest that the exorbitant spot market prices were unanticipated by the market and are likely to persist in the coming years. 

Significant NEM baseload generation was unavailable 

The majority of the National Energy Market’s baseload capacity (around 70 per cent of the total) comes from coal-fired generation.

During Q2 2022, a large number of scheduled and unscheduled coal generation and gas baseload outages led to tight supply conditions across most of the NEM.

In simple terms, unexpected outages restricted the volume of generation capacity, meaning that the market cannot respond to shocks adequately.

It also means that more expensive generation, such as high-peaking gas power plants, needs to be brought into the mix to meet demand more often.

At the peak of the crisis, almost 8,000 MW of capacity was unavailable due to outages. The AER said that overall outage levels in 2022 were still particularly high.

The regulator also stated that coal generation in the National Energy Market is ageing and becoming unreliable and could become an increasingly more important factor in grid stability in the future.

International fuel prices have increased sharply

The war in Ukraine has pushed international fuel prices including coal, oil, and LNG through the roof. 

The resulting international price hike put pressure on domestic prices because exporters are more inclined to sell into the export market where they can receive a higher return.

The price of coal

At the start of the COVID pandemic and up to late 2022, the price of coal converted from price per tonne to MWh of electricity was below $50.

Fast forward to June this year, and prices, the marginal cost to generate was above $225/MWh. Generators that need to source spot coal now require very high prices to generate electricity.

(Note prices in charts are $USD)

Newcastle Coal futures peaked at AU$ 720.80 per metric tonne on September 5, dropping fairly sharply to AU$606 per tonne on October 7.

The price of LNG

International prices for liquid natural gas have also increased substantially. Asian gas prices reached record levels with price volatility ranging between $27.24/GJ and $63.12/GJ during April-July.

Prices in Europe reached a daily maximum of $83.15/GJ during the same period. International prices dropped in May-June 2022 as European stockpiles were rebuilt when flows from Russia to Europe resumed.

However, international prices increased again following a Freeport gas explosion, which reduced US LNG exports and Russia closed the tap on the Nordstream 1 Pipeline to Europe once more.

In August 2022, international prices increased further to record highs of $100.53/GJ in Europe and $77.16/GJ in Asia.

Supply constraints

Supply constraints also contributed to high energy prices. Coal generation plants usually operate with a stockpile of fuel held back in reserve.

This allows them to adjust to short-term shocks to supply due to flooding or when demand may be particularly high due to outages or seasonal factors.

The high number of outages in April 2022 led to some coal generation units running at higher levels than anticipated. 

Flooding and technical issues at mines led to stockpiles falling to dangerously low levels, causing some generators to withdraw generation capacity. 

Another factor that needs to be considered is that specific generators require a particular grade and type of coal, which may not readily be available.

In addition, stockpiles are not readily relocatable, so if a generator goes offline, its reserve stockpile is also taken out of the mix. 

As discussed earlier, export prices for coal are currently very high, meaning that local suppliers face strong incentives to sell to the international market over the domestic one. 

LNG export pressure 

When domestic gas prices are higher than international prices, Australian LNG producers should face increased incentives to sell into the local market.

Between May and June 2022, local prices were higher than exports, but the AER found that a substantial amount of gas flowed north to Gladstone to be shipped overseas.

The AER said one explanation could be that LNG producers committed to selling their available gas for export before May and could not supply to the domestic market despite the incentive of high prices. 

LNG producers maintained export volumes similar to 2021 despite much higher domestic prices. This year, 30 cargoes of LNG were exported in May 2022 compared to 28 in 2021 and 26 in 2020.

AEMO has intervened in the gas market on two occasions, which increased gas flows south.

Two LNG producers took their “trains” offline in June and July. Trains convert natural gas to a liquid form that can be exported.

This meant that the local market got an injection of extra gas, but the reprieve is expected to be short-lived once the trains are returned online and export conversion to LNG resumes. 

Solar

Solar energy output has been lower than anticipated due to the La Nina phenomenon.

The weather pattern caused by La Nina resulted in less solar radiation.

Solar tends to be offered to the market at low prices, so when it is not available more expensive generation is required, contributing to high energy prices. 

Wind 

There was a similar trend for wind as for solar. In weeks where the wind is low, other generators need to operate at higher levels to meet demand. 

Wind generation in South Australia, which is particularly vulnerable to drops in output, was very low in the lead-up to the suspension of the NEM in June. 

Gas storage levels are critically low

Demand in winter for gas is significantly higher than for the rest of the year.

Stockpiling of gas is particularly important in Victoria through the winter months because gas production and pipeline capacity to transport gas to demand centres are not always sufficient to meet daily demand.

The gas stockpile in Victoria for Q1 and Q2 of 2022 was considerably lower than normal.

In recent times, gas-fired generation has been called up less to fill in gaps in demand due to the increased share of cheap renewables.

However, Q2 2022 told a very different story. A reduction in the availability of coal-fired electricity generation and low renewables generation led to increased use of gas-powered generation

Demand for gas was particularly prominent in NSW which rose by 225 per cent compared to Q2 2021.

Hydro generation has run harder but pulled back due to floods

Hydro generators have limited ability to increase generation to cover the shortfalls in other generation types, as they generally have limited water in storage and environmental obligations on flows. 

Hydro generation is required to plan its generation over the year, considering the opportunity costs of consuming water now compared to later in the year. 

These generators also need to consider the cost incurred to pump water back up to the summit to release when electricity is needed. 

During periods of high flows and flooding, there were restrictions on the ability to release water from certain dams, to help reduce flooding downstream. 

When hydro increases generation above what’s planned, their ability to generate later in the year may be restricted.

This explains why a hydro generator’s offers into the market will be closely linked to the offers of other generators.

When the offers of coal or gas generators increase, hydro generators must also increase their offers or run the risk of depleting their water reserves for peak periods.

Do you need more information about electricity price drivers?

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